The effect of tax code complexity on entrepreneurship.

Author:Weber, Rick
  1. Introduction

    The federal tax code in the United States is incredibly complex. However, little attention has been paid to complexity in states' tax codes. Gupta and Mills (2003) estimate that the 1,000 largest public firms face state tax compliance costs of around $300 million and federal tax compliance costs of around $1 billion. These compliance costs represent approximately 2.9 percent and 1.4 percent of their state and federal tax expenses, respectively (Gupta and Mills 2003). The cost of tax code complexity likely generates economies of scale due to expertise or experience in navigating required paperwork, so that the relative importance of these costs is likely higher for new ventures. Dealing with a complex tax system may be outsourced to an accounting firm, but it still adds a fixed cost that increases the minimum efficient scale of a business.

    What is not clear is how large an impact such complexity has on entrepreneurial activity. Complex tax codes affect American entrepreneurs from the federal level down to the local level and add compliance costs at each step. This study will examine the effect of state tax code complexity. Data collected for this research suggest that such complexity is a fraction of that at the federal level, with the Internal Revenue Code estimated to be over 3.4 million words (Walker 2013). Because this study allows a cross-sectional comparison, it will offer insight into the economic effect of tax code complexity. The findings of this study suggest that tax code complexity at the state level matters, and by extension that federal tax code complexity may have a profound impact on entrepreneurs.

    There are at least three big questions to ask about the complexity of a tax code: (1) How do we measure complexity? (2) What is the impact of complexity on economic agents? (3) What causes this complexity? This paper investigates the first two questions. I use word count as a proxy for complexity and regress business entry rates and business exit rates on word count (as well as control variables).

    There is an extensive literature investigating entrepreneurship, institutional quality, and economic growth, but the literature on tax code complexity is relatively small and there are few papers connecting the two. This paper fills that gap with a comparative study of tax code complexity across states and the impact of that complexity on levels of entrepreneurship. This paper also introduces an innovation in the empirical entrepreneurship literature by examining business failures rather than just startup activity. By ignoring failure, the existing literature misses an important variable that is an inescapable part of a dynamic economy.

    There are three common technical conceptions of entrepreneurship (Bjornskov and Foss 2008). In the Schumpeterian view, entrepreneurs innovate, and in doing so, they breed creative destruction (Schumpeter 1911). The Kirznerian view is that they can discover profit opportunities, and in their alertness drive the process of market equilibration (Kirzner 1978). The Knightian view is that they make judgments in the face of uncertainty (Knight 1921). All three conceptions are complementary and capture important facets of entrepreneurship, but the Schumpeterian view is especially important for this study. Specifically, business failure captures the "destruction" in creative destruction and it is this aspect of Schumpeter's ideas to which the title of this paper alludes. Baumol (1990) points out the need to distinguish between productive and destructive entrepreneurship; the former creates wealth through mutually advantageous exchanges while the latter makes a few entrepreneurs rich by imposing costs on others. Lobbying for tax loopholes is an example of destructive entrepreneurship. Understanding this possibility is important for interpreting the results of this study.

    The theory of entrepreneurship is well developed, but measuring entrepreneurship is a difficult proposition. Because there are many aspects of entrepreneurship, there are a number of places to look for entrepreneurship. I use a measure of business entry rates as used in Campbell and Rogers (2007), Bacher and Brulhart (2013), Sobel (2008), and Powell and Weber (2013). Unlike the cited studies, I supplement this measure with business exit rates to get a better view on the dynamism of Schumpeterian entrepreneurship. Existing literature measures entrepreneurial activity by looking at positive measures of entrepreneurial activity (such as business entry), but using entry alone paints an incomplete picture. Looking at failure is important because it gets at the destruction in Schumpeter's idea of creative destruction. In 1900, the United States had over 10,000 carriage manufacturers (Carriage Museum of America 2013). These businesses were displaced by a smaller number of automobile manufacturers; an estimated 1,500 automobile manufacturers have operated in the United States since 1896 (Dreyer 2009). This case makes it clear that a business unable to compete with entrepreneurial newcomers may fail, and that the number of failed firms may outnumber the number of entrants. While other factors may cause business failure, the appropriate statistical controls can allow us to safely conclude that failure is indicative of entrepreneurship rather than, for example, a general economic slump, or retirement by a firm's owner-operator. Macroeconomic and demographic controls used in this study help to control for such issues. With these caveats in mind, business failure can be thought of as a symptom of entrepreneurial success (of other businesses) that frees up resources for innovators to expand on their success. This logic is confirmed by Sobel, Clark, and Lee (2007), who find that economic freedom is positively associated with entrepreneurship as measured by the Global Entrepreneurship Monitor and business failure rates.

    As economists, we are concerned with entrepreneurship because it is the driving force of the market process. Entrepreneurship is fundamentally about experimentation and discovery, and failure is an integral part of this overall process. In seeking profit opportunities, entrepreneurs arbitrage price differences, make use of innovations, and reallocate resources to more accurately reflect the desires of consumers and the opportunity costs of productive factors. Companies' shrinking and ultimately going out of business is a part of the process of moving factors of production to their highest valued use. If inefficient businesses are not shutting down in the face of "the perennial gale of creative destruction," this is a sign that something is impeding the entrepreneurial process.

    Yamakawa, Peng, and Deeds (2010) offer an important contribution in which they find that, under certain conditions, individual entrepreneurs learn from their failed enterprises. This learning allows them to be more successful in subsequent ventures, showing that entrepreneurial failure is also an input to future success. In addition to the beneficial aspects of failure discussed above, we can think of business failure as a source of hands-on education ("the school of hard knocks").

    There has been much research on the connection between institutional quality and entrepreneurship. (1) Studies in this literature that look at the United States typically use the Economic Freedom of North America index to measure institutional quality (Avilia, Ashby, and McMahon 2012). It includes measures of the size of government, taxation, and labor market freedom. Kreft and Sobel (2005) and Sobel (2008) find a strong correlation between EFNA scores and entrepreneurship, as well as between entrepreneurship and living standards.

    But these measures of institutional quality and economic freedom do not look at tax code complexity. There is a literature examining the impact of tax code complexity on costs of compliance (e.g., Gupta and Mills 2003) and levels of compliance (e.g., Forest and Sheffrin 2002). These measures are important, but overlook a third facet of this issue. When you see a complicated tax code, you have three options: deal with it (in which case we want to know about compliance costs), cheat (in which case we are discussing compliance levels), or walk away entirely. This third issue is the focus of this paper. How does complexity affect entrepreneurs' decision to go into (or remain in) business? This issue has implications for the overall dynamism of a market beyond issues of static economic efficiency and public finance.

    Bacher and Brulhart (2013) investigate the effects of Swiss canton and...

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